An economy built on debt? Bank of England on alert after it confirms high levels of mortgage debt made the recession worse

The Bank of England said it will 'monitor closely' levels of household debt after it published analysis suggesting rises in mortgages before the credit crunch boosted spending and growth, but made the recession worse.

The Bank's quarterly bulletin suggests that those households with high levels of mortgage debt made larger cuts to their spending after 2007, when the banking system froze and credit became far harder to obtain - despite an interest rate policy that sheltered most borrowers from any rise to monthly repayments.

Consumer spending accounts for about two thirds of GDP, the bank said, so any fall in household spending hits growth hard.

Payback time: The Bank has confirmed it will watch levels of household debt closely.

A rapid rise in mortgage debt prior to the credit crunch had inflated household spending in general, boosting growth, but much of this was reversed when the crisis hit.

The Bank said: 'In the second half of the 1990s, households with mortgage debt to income ratios greater than two appear to have increased the share of their income spent on non-housing consumption by more than mortgagors with lower debt to income ratios.

'But these higher debt mortgagors subsequently made larger-than-average reductions in spending relative to income after the financial crisis.'

'The largest adjustment in spending relative to income after 2007 came among households with a mortgage debt to income ratio above four', it added.

Interest rates were slashed as the recession hit, falling to 0.5 per cent in March 2009, where they have remained ever since. This ensured mortgage borrowers often felt no rise in their monthly repayments, even if they could not remortgage at the end of a fixed-term mortgage deal.

Belt-tightening: The graph shows how households with higher debt to income ratios cut spending by more.

However, this did not prevent highly indebted households cutting spending by more than households with lower debt.

The Bank said this was because the indebted had to cut spending by more as they were unable to renew or increase existing debt.

Additionally, concerns about possible falls in income that were felt by all during the recession had a bigger impact on the spending of the indebted because these households needed to plan more carefully in order to meet their repayments.

The UK's household debt to income ratio rose from around 100 per cent in 1999 to a peak of 160 per cent in 2008. Mortgage debt accounts for around 80 per cent of total household debt, and explains most of the increase in the debt to income ratio, the Bank said.

That the Bank has identified the dragging effect of household debt on spending during times of recession is significant because it marks a change of attitude by rate setters. Received economic wisdom, the bank said, has been that that debt plays no role in overall spending in the economy.

In June, the Bank introduced measures to designed to prevent dangerously high levels of indebtedness. Mortgage lenders now have to be satisfied that borrowers would be able to meet repayments if the Bank Rate were to rise 3 percentage points.

Lenders must also limit the proportion of mortgages of 4.5 times income and above to no more than 15 per cent of new loans.

These measures could be tightened further if the Bank becomes more worried about household debt.